Rising economic woes test Europe's leaders

March 11, 2009

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The result is a massive budget deficit of nearly 10% of gross domestic product, which will require sizeable borrowing by the Irish government. Markets have responded by driving up the cost of credit-default swaps, a form of insurance against Ireland defaulting on its bonds, to more than 355 basis points, vs. just 31 basis points before the Lehman Bros. bankruptcy in mid-September. Likewise, Ireland now must offer investors 2.7 percentage points higher yield on its bonds than rock-solid German government debt.

On Friday, the ratings agency Fitch, joining Moody's and Standard & Poor's, said Ireland was in danger of losing its AAA credit rating unless it repaired its tattered finances.

If Ireland or another PIIG nation does default, the consequences — in an already fragile global environment — could be serious for both global market psychology and the euro. Most analysts expect that Germany would ultimately help fund a bailout, most likely through the auspices of the IMF or one of the European multilateral institutions. Joaquin Alumina, the EU's monetary affairs commissioner, said earlier this month the bloc had an unspecified "solution" for eurozone countries at risk of default. "By definition, this type of thing should not be explained in public," he said.

For investors, that vague promise raised more questions than it answered. But the uncertainty about how the costs of a bailout, for old or new Europe, would be allocated has investors taking a hard look at Europe's political and financial structures. Europe's monetary union "is being stress-tested for the first time in its history, and this is a severe test," says Morgan Stanley's Jen. "We don't know what the outcome is. And nothing can be ruled out."